The Grossman Stiglitz Paradox - Collaboration with Ben Felix | Summary and Q&A

TL;DR

Markets cannot be fully efficient because information used to make active investment decisions is expensive to acquire.

Key Insights

• 💁 The Grossman Stiglitz paradox challenges the notion of market efficiency, arguing that the cost of acquiring information makes fully efficient markets unlikely.
• 👶 In efficient markets, stock prices adjust quickly to new information, making it difficult for active investors to consistently outperform the market.
• 🧑‍🏭 Active investors estimate the intrinsic value of stocks using methods like the discounted cash flow model, considering factors like profitability and risk.
• ☢️ By buying undervalued stocks, active investors contribute to stock prices moving towards their intrinsic value.
• 💁 Prices in the stock market reflect both general information available to everyone and individual participants' specific knowledge.

Transcript

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Questions & Answers

Q: What is the Grossman Stiglitz paradox?

The Grossman Stiglitz paradox argues that markets cannot be fully efficient due to the high cost of acquiring information for active investment decisions.

Q: What is market efficiency?

Market efficiency means that prices always fully reflect available information and adjust quickly to new information.

Q: Why do index funds work well in an efficient market?

In an efficient market, index funds work well because there are no undervalued or overvalued stocks that can be exploited for above-average returns.

Q: How do active investors estimate the intrinsic value of a stock?

Active investors estimate the intrinsic value of a stock by using methods like the discounted cash flow model, considering factors such as future profitability and risk.

Q: How do active investors impact stock prices?

Active investors apply upward or downward pressure on stock prices depending on whether they believe a stock is undervalued or overvalued, respectively.

Q: Why do prices react to positive or negative news in the stock market?

Prices react to news because analysts update their models with new information, which changes their estimated price and leads to buying or selling, altering the stock price.

Q: How does competition in the stock market affect prices?

Competition in the stock market leads to prices reflecting general information that is widely available, as well as each individual participant's specific knowledge and insights.

Q: Why is there a coexistence between active and passive investment management?

Passive management relies on active management to move stock prices closer to their intrinsic value, while active management benefits from passive management to avoid excessive market volatility.

Summary & Key Takeaways

• The Grossman Stiglitz paradox argues that markets cannot be fully efficient because the cost of acquiring information for active investment decisions is high.

• In an efficient market, stock prices should always reflect available information and adjust immediately to new information.

• If everyone started to index in an efficient market, prices would have no way of adjusting to new information.